Does no contract indicate a good relationship?

November 25, 2015

There are many who see ‘the relationship’ and ‘the contract’ as independent elements – and indeed, who perceive the contract as potentially damaging to the relationship.

As I work with companies around the world, I am increasingly discovering that this is often far from the truth, especially in the case of larger corporations. An example arose in a conversation that I had yesterday with a former senior supply chain executive with one of the world’s best known brands, whose ‘no contract, just a handshake’ approach has been taken to indicate strong and collaborative relationships.

According to this executive, the ‘no contract’ approach applied only to the top-tier suppliers with a ‘strategic relationship’. These were indeed closed ‘with a handshake’. Other transactional suppliers always had a contract of some sort – e.g. a purchase order.

However, behind the scenes, the appearance of ‘collaboration’ masked the fact that the corporation in question was using the lack of contract as a lever to pressure its suppliers. In fact, in recent years, the top tier suppliers started to ask for contracts to protect themselves from what they saw as ‘abusive behavior’. According to this former executive, the reason for the no-contracts approach was not because of a close, collaborative relationship, but was actually because the customer didn’t want to be committed. They used this lack of commitment to threaten the suppliers with discontinuance if they did not meet requirements. This way, they pushed suppliers to take low prices or to bear the risks of entering new markets. It was made clear to top-tier suppliers that ‘they were accountable for growth’.

Driven by these approaches – and the very low margins that resulted – there was substantial market consolidation, so over time the power balance shifted and suppliers were no longer prepared to accept the one-sided relationship. They insisted on having contracts. This need for contracts was actually becoming mutual because of issues such as regulatory compliance, which required far more discipline.

Within the customer organization itself, I am told that the handshake system contributed to a culture of limited executive accountability. Since handshake agreements depended on personal relationships, they often eroded – damaging performance, trust and sustainability. When things went wrong, executives were able to deny accountability since there was no written record, no set of commitments, no signatures.

The story is fascinating because it shows the very real risks of short-term, cost-based behavior based on market power. It is tempting for top management to use such power in its supply management strategies, but as this example shows, such an approach cannot be sustained. Rather like the automotive industry, which for many years exhibited similar aggressive tactics, it will take a long time to restore trust and, in the meantime, corporate performance will suffer.

Once again, we see the important role that contracts should play in ensuring an ethical framework to a relationship and establishing ‘the rules of play’. Rather than seeing no contract as a good thing, perhaps it should raise our suspicions about the true intent of our counter-party.